Wednesday, December 2, 2009

Lessons from Dubai crisis

The not-so-unexpected decision by the Dubai Government to request its banks for a six-month stay (atleast till May 30, 2010) on the $59 bn worth debt repayment obligations of Dubai World, the corporate arm of Dubai and which has led many of its most ambitious real estate projects (and which also operates Dubai's world class port, including the Jebel Ali free trade zone), and the markets reaction to the announcement raises a few interesting issues.

1. Abu Dhabi, the oil rich governing emirate of the United Arab Emirates, for maybe political reasons, initially showed remarkable resolve to not to jump in with an unconditional bailout of the investment arm of one of its own states or even purchases of Dubai's debt. It forced the Dubai government formally announce its distress and thereby bring its (often greedy and irresponsible) creditors to the negotiating table for a genuine debt restructuring deal and share in the pain inflicted by the losses.

This stand-off attitude (by both governments), instead of the more direct and immediate bailouts (atleast some of the more dubious ones like the infamous AIG payouts) that chacterized much of the US government response during the height of the sub-prime crisis, deserves commendation. The decision to refrain from a blanket support for creditors of Dubai World was aimed at forcing out concessions from the irresponsible creditors who deserve an equal share of the blame for the mess.

Interestingly, Dubai World had already raised $5 billion from Abu Dhabi banks on Wednesday, making it possible to pay the $3.5 billion to the holders of its Islamic bond by Dec. 14. However, it decided not to go ahead with payment and sought a moratorium on debt repayment for six more months so that they could work together or risk not being paid at all. As the Times writes, for the bankers, not to be paid would raise the prospect of more write-downs at a time when the industry has absorbed more than a trillion dollars in losses related to bad mortgages and is still recovering.

Abu Dhabi which sits on 9% of the world’s oil and manages the largest sovereign wealth fund, has on other occasions too shown a healthy restraint in refusing to unconditionally cover for the losses of its emirates and write blank cheques to cover all their debts.

2. The subsequent decision by the UAE Central Bank to pledge to lend money to banks operating in Dubai, after a week of turmoil that ravaged the stocks of these banks and those with exposure to them, was aimed at pre-empting the kind of crisis of confidence that froze credit markets last year in the aftermath of the Lehman failure in September 2008. Then the markets got back to some ssemblance of sanity only after the US Government announced a massive $700 bn banking bailout plan and guaranteed a variety of borrowings. This latest decision is only the latest example of the moral hazard that has been unleashed in the financial markets by the risk of system-wide contagion of banking failures.

The Abu Dhabi government's decision is not a blanket guarantee of all of Dubai's debt, but is obviously a dilution of its hardline stance from last week, and is a reflection of the dilemma and pressures faced by governments during such crises.

3. The steep increase in spreads on even Dubai government debt and cost of capital for Dubai government, in the face of what is essentially a private debt crisis, is a clear indication that the distinction in debt ownership may have disappeared. With governments forced into mounting massive bailouts and guarantees for its private "too-big-to-fail" financial institutions, their deficits threaten to spiral out of control.

And Dubai is not alone in this - the cost of insuring debt issued by Greece, a member of the euro bloc, is now as much as insuring Turkey’s debt, an investment that was once considered much riskier. Greece, whose short-term debt burden has risen from $14.5 billion at the end of 2007 to $24 billion in the second quarter of 2009, has many others in Eastern Europe for company. Hungary, Bulgaria and the Baltic states of Latvia, Lithuania and Estonia carry foreign debt that exceeds 100 percent of their gross domestic products. In fact, Eastern Europe is precipitously perched in much the same situation as the East Asian economies in the late nineties.

All these economies face the problem of massive private sector debts, with a substantial portion being short-term, All this raises the importance of a trans-national mechanism, that goes beyond the limited mandates of multilateral institutions like the IMF, to address such crises.

4. The decision by the Dubai government, which was not a default but only a postponement or a rescheduling of the repayment obligations of one of its government backed agencies, was seen by the markets as equivalent of a sovereign bankruptcy. Legally neither Dubai nor Abu Dhabi are bound to guarantee the debt of Dubai World. The prospectus for Nakheel that lays out numerous warnings, including that Nakheel has relied "upon capital contributions from the government of Dubai" and "there can be no assurance that these contributions will continue".

Questions are being asked about whether Dubai government will default on its other repayments, and the cost of capital for Dubai itself has risen steeply. However, the real and spectacular achievements of Dubai in building up its remarkable success story from a barren desert cannot be compared to the illusory gains from paper transactions of modern financial engineering that kept much of Wall Street pumped up in recent years. The markets have also overlooked the fact that the parent government, Abu Dhabi has more oil than Dubai, has no cash problems, and could easily wipe out Dubai World’s $59 billion of debt.

Faced with similar implicit government guarantees, the global financial markets did clearly give the benefit of doubt to the stumbling Wall Street firms, most notably the Citigroup, at the peak of the sub-prime crisis. But in case of Dubai World, with a debt burden built on arguably less shaky foundations, the reaction of the global financial markets appear similar to that with the East Asian economies in late nineties. In the circumstances, the market reaction casting doubts on Dubai government itself may be a reiteration of the fact that emerging economy governments face much greater risks with global financial market shocks.

5. The news battered the stocks of these banks (like Barclays, Standard Chartered and HSBC) and Dubai World's entities and those with Dubai exposure. The debt rescheduling is the latest blow to Dubai World diffuse portfolio, which has plunged in value due to the global financial market and economic distress that has battered the real estate market. The bonds of Dubai World’s property developer, Nakheel, the developer of Dubai’s signature palm-shaped islands, dropped sharply and the cost of insuring against a Dubai government default soared.

6. FE has this nice graphic on India's exposure to Dubai. Dubai's woes could also but breakers on the flood of capital into the financial markets of emerging economies. Ironically this could be a positive development for these overheated markets.

See also this superb post by Ed Glaeser on Dubai's spectacular government driven growth story which sought to create a world class business environment in a barren desert, and which in the process may have over-reached with the consequences that we see now. However, the real achievements, which will surely endure the crisis cannot be overlooked.

See also this article from Andrew Ross Sorkin which draws attention to how Shariah compliant investment products helped channelized the massive savings of wealthy, oil-rich Muslim investors and finance a substantial share of Dubai World's investments. With the Koran prohibiting investments that pay interest, the natural investment alternative was real estate, one which also suited the ambitions of Dubai World's promoters.

Update 1

See also this on the Duabi debt crisis

Update 2
Abu Dhabi government finally stepped in with a $10 bn short-term loan to embattled Dubai, which comes with more closer scrutiny of the so-far free-wheeling Duabi government's investment decisions.

Update 3 (25/3/2010)

The government of Dubai has announced putting up to $9.5 billion into Dubai World and its subsidiary Nakheel PJSC to help them restructure debt. The Nakheel bonds falling due this year and next will be paid by Dubai World, which is the chief investment vehicle for Dubai. Nakheel, the company’s real estate development unit, will receive about $8 billion in the new government funds.

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